Pandas were taken off the endangered species list earlier this year, but unicorns seem to have been added to it lately. VC-backed billion-dollar companies have exited more than new ones have been funded this year. This suggests investors are a lot more cautious about investing in startups than they used to be, preferring to get their older investments sold or sent public.
That means new startups courting investors may face even more scrutiny and skepticism than they would have even a year ago. These seven venture capitalists explain what their due-dilligence tests consist of right now, and what it takes to pass them.
1. Show That Customers Are Breaking Down Your Doors
“The number-one indication of the company being successful or not is its customers. That’s where I start with due diligence,” says Sonja Perkins, founder of the all-women angel/VC powerhouse group Broadway Angels. “I’ll directly talk or meet with customers and ask them the following three questions: First, ‘What is your problem?’ Second, ‘How are you solving this problem today?’ and lastly, ‘How would this new solution solve this problem for you?'” There better be a lot of customers to interview, she says, even potential ones.
Perkins continues, “I don’t ask two or three customers, I interview several. My favorite company is the one that’s doing well despite itself. Maybe the company’s founder isn’t too polished or the infrastructure is a bit weak, but if customers are dying to have the solution, I know I have a winning investment.”
Laurent Grill, an investor at Luma Launch in Los Angeles, goes even further when companies are young. “Likely, early adopters of a product (e.g., Kickstarter) will skew into a smaller demographic than the eventual larger market,” he points out. “We need to know an extended demographic that could adopt the company’s product at scale.” Grill continues:
Therefore, asking current customers of early companies about their experience can be misleading due to their intrinsic [knack] for risk-taking on companies or early products. Instead, I do a scalability risk analysis and reach out to the potential demographic for the company. This is an effective way to make educated assumptions on the ability for a company to bring their product to larger mass market.
2. Let Investors In On Your Product Evolution
Beyond adoring current or potential customers, a product’s evolution is a key mark of how well founders can adapt. But Kevin Zhang, principal at Upfront Ventures, says most startups today don’t have the robust financial models or expensive research reports he got used to seeing as a management consultant with the Boston Consulting Group. So as an investor, he’s had to turn to other metrics.
“That’s why I’m so focused on the product demo process,” Zhang says. “In the absence of significant quantitative data, the early product evolution is a mirror for a founder’s innate grasp of customers’ needs, and how they will iterate to solve them.” Before Upfront decided to fund entrepreneur Todd Hooper’s live-streaming VR platform VREAL, Zhang recalls, “I saw multiple versions of the product over six months of meetings. Each time, features were refined and stability improved with careful, user-centric reasoning behind every change.”
Getting a front seat to this process was crucial, Zhang says. “The product evolution was evidence of thoughtful debate and hard decisions around balancing user needs with revenue opportunities and measured resource allocation.” Ultimately, Zhang says he felt confident that Hooper and his team “would manage the user experience and the business with careful consideration to every stakeholder” and decided to back VREAL.
3. Show You Can Manage Competing Interests
Founders who can showcase great management skills as diverse interests multiply and business demands mount is critical for investors in the current startup environment, too. Ben Sun, Partner of New York City–based Primary VC, puts it bluntly: “About 80% of our investment decision is based on our belief in the entrepreneur.”
Sun says he and his team evaluate entrepreneurs according to three key questions. “First, would you work for this person? A great company will only happen if the entrepreneur can build a great team. If a founder can’t attract great people, we’ll pass on the deal, no matter how great the idea is.”
The second question, says Sun, is, “Can this person sell stock? Being able to raise money is a real skill. If the company’s runway is really short, they can go out of business very quickly.” Sun’s last question surrounds the “cheetah vs. lamb” debate on the importance of emotional intelligence. Quite simply, Sun says, “We look for cheetahs.”
4. Get Your References In Lockstep
Like Perkins, Allison Thoreson Bhusri is an investor with Broadway Angels, and she also has a protocol for investigating founders’ characters. She does that “both directly and through back-channel references. Confidence and an almost irrational optimism are needed,” says Bhusri, “but too much arrogance is a red flag.” Bhusri says Kurt Workman and Jordan Monroe at Owlet and Meaghan Rose at RocksBox all had solid, consistent back-channel references. “I learn a ton from back-channel calls, and this homework makes me a better advisor to the company if I do end up investing.”
“I learn a ton from back-channel calls, and this homework makes me a better advisor to the company if I do end up investing.”
Chirag Chotalia, principal at DFJ, also talks with references in order to assess founders’ “motivation and desires for the business.” That’s crucial for understanding “the team’s ability to execute,” Chotalia says, but that isn’t always evaluated:
Unlike financial or market diligence, there’s no scientific way to approach this. It’s the result of many direct conversations with the team, speaking to people they’ve worked with in the past–both prior investors if they’ve raised capital prior–and direct reports and former managers.”
Investors’ goal in these discussions, says Chotalia, should be “gauging how the team has handled situations in prior contexts,” then using that to predict its future performance.
5. Be Ruthlessly Honest
Lastly, investors want plain honesty. “It’s the nature of startups: we will inevitably go through tough times together,” said Jennifer Carolan, a partner at Reach Capital. “As an institutional investor, I expect to be working closely with the founding team for years. It’s critical that we can trust one another and that the founder can be open about the problems so we can tackle them together.”
Eight years ago, Carolan led diligence on BetterLesson, founded by Alex Grodd. “He was very honest about himself, the early limitations of the product, and the tough market outlook,” she recalls. “He did not overpromise. Fast-forward to today, I still sit on his board and can say that his veracity and character are key reasons why the company has grown into a market leader.”
Perhaps the best way to save the thinning herd of VCs’ unicorns? Companies of cheetahs with character, customers, and the ability to change. After all, investors’ relative cautiousness doesn’t have to mean fewer opportunities for entrepreneurs. That can even work in startup founders’ favor–by giving them more chances to prove their mettle.
Beck Bamberger founded BAM Communications in 2008 and writes regularly for Forbes, Inc., and The Huffington Post about entrepreneurship, public relations, and culture.
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